The bond market came back from a 3-day weekend to find yields rising on Tuesday. This pushed mortgage rates to their highest levels in two years, and increased focus on what was already the highest rate hike since late 2016.
Why are rates rising so fast?
Mortgage rates are based on mortgage-backed securities (MBS), which are essentially bonds closely related to US Treasuries.
The Federal Reserve (Fed) has been buying both Treasuries and MBS (mostly in operation) since 2009 as part of various stimulus efforts. Higher demand for bonds means higher bond prices, lower bond yields, and therefore lower interest rates, all other things being equal.
Since the pandemic, bond-buying has been intended to help the US economy return to full employment and “price stability”. By the fall of 2021, it is becoming increasingly clear that the labor market will not return exactly the same shape and that inflation will be more steady than the Fed expected. As such, the Fed warned that it would start ending bond purchases in September, eventually driving the trigger at the next meeting in November.
There are two phases to such a cooldown. The first involves reducing the amount the new Buying bonds. Once the Fed finishes tapering, their balance sheet stops growing, but they continue to buy bonds with the proceeds of previous bond purchases. By reinvesting that proceeds, the balance sheet remains the same. The second stage involves shrinking (or “normalizing”) the balance sheet by setting progressively smaller limits on the size of reinvestment.
Since then, the gradual warning in September, long-term rates have risen and seen more volatility. The emergence of Omicron was an obstacle that forced prices to cool off in early December. Then traders waited for clarification on the impact of Omicron and the improved liquidity that was sure to arrive in the new year.
When new trading positions began appearing on January 3rd, they were heavily skewed towards higher rates. Despite the high number of cases, the market has been devouring the narrative that Omicron may paradoxically have a positive turning point in the pandemic.
Two days later, the Federal Reserve released the minutes of its December meeting which unexpectedly revealed an accelerated expectation of balance sheet normalization (the second phase of the Fed’s purchase of lower bonds).
Almost all the drama in mortgage rates in the past three weeks is due to this shift in Fed policy expectations!
Why didn’t prices jump directly to current levels after the Fed minutes?
These things take time. When the Fed pivots, we tend to see an initial boom in the bond market and then several aftershocks. It was the same when the Fed warned of tapering in September. There are even similarities in trading patterns that may indicate the risk of a further move towards higher rates.
The highlighted section of the September/October chart shows the market digesting the Fed’s diminishing warning. The most recent shaded section shows the comprehension of the settlement warning.
Another factor that forces bonds to avoid taking a straight line towards higher rates is the stock market’s reaction to the news. While the Fed may not buy stocks outright, stocks nonetheless tend to frown when the Fed signals intentions to tighten policy. It was no different this time, it created a clear “inverse picture” pattern between stock prices and bond yields.
If the stocks lose enough ground, some of the money withdrawn from that side of the market finds its way into the bond market. This was increasingly evident as the week progressed as the past two days have seen a strong correlation between stock prices and bond yields.
So the rates are higher because of the Fed, but they got a respite because of the stocks?
Yes and no. Rates are almost exclusively higher in 2022, and they haven’t recovered much. The massive losses in stocks share some of the stimulus with the price hikes (both upset by Fed policy), but they also helped limit the pace of price hikes.
Furthermore, the charts above use the 10-year Treasury yield as a representative of the entire price market. Mortgage rates have not been as good as Treasuries because MBS is more sensitive to changes in Fed bond buying expectations. The following chart shows how mortgage securities have underperformed Treasuries since the Fed began tapering, and again after the normalization comments in the Fed minutes.
Aren’t rates historically low?
“Historically low” often depends on how far you want to look back. We are now much better off than ever before covid. If we only look at the past two years, rates are at an all-time high. This refinancing activity reflects this reality (rates are low enough to motivate some, but high enough to bring the reference to its lowest level since before Covid.
Does this have anything to do with the Fed rate hike?
Not real. Expectations of a Fed rate hike can have an impact on mortgage rates, but rate increases themselves are often old news by the time they happen. The market is in strong agreement that the Fed will raise interest rates at the March meeting.
What about the Fed meeting next week?
actually! Next week’s Federal Reserve meeting is a focal point for potential market volatility. The Fed will not announce any policy changes, nor will it raise interest rates. But remember, they didn’t announce any policy changes either in September. Reply rates anyway.
Traders will be very curious to see what the Fed writes about its expected March rate hike and, more importantly, the timing of its balance sheet normalization efforts. In addition to the written statement, Powell’s press conference can also be a source of actionable information for traders. This is all happening Wednesday afternoon (January 26), and could easily serve as a springboard for the next big move in interest rates.
Could this movement be only higher?
If we knew that now, we wouldn’t have much to discuss. While the overview, “all things equal” is for progressively higher rates, things don’t always go as planned. If Powell slams the brakes on the Fed’s tighter stance lately, surely prices could catch a breath in a more meaningful way than they have this week.
Don’t take this as a prediction though! It’s just one of several potential options. Powell could double down on his hawkish stance and that could easily revitalize recent rally rates.
Could the geopolitical drama surrounding Ukraine or Taiwan help keep prices low?
This is a complex question to consider, but the answer is simple: only if things go wrong unexpectedly. Since the imminent risk is of some sort of a repeat of the 2014 Russian invasion of Ukraine, let’s consider the market’s reaction in 2014. For bonds, the two most peaked months of the Crimean annexation were actually the quietest months of the year.